Greg Ip of the WSJ published an article in the Feb.7 edition which should be of some interest to ERs, ER wannabees, and future Rs (like me). The Page 2 article is entitled Low Interest Rates May Be The New Norm.
He examines the curious current state of low long term rates. The current 10 year Treasury Bond rate is hovering around 4%. Wall Street consensus is that will increase to 5.2% a year hence.
Wall Street fundamental case for higher long term rates: U.S. economy is strengthening; fear of deflation has evaporated; Fed raising short term rates on a measured pace; and, the twin deficits are getting larger. Why has the long end stayed so low? Wall Street says temporary factors including higher demand for bonds by underfunded pension plans, reduced supply from mortgage markets, the carry trade, and, Asian Central bank Treasury buys to prop up local currencies vs the dollar.
Alternative minority view: Long term rates are composed of two components an inflation premium combined with a real rate of return. Inflation expectations have been permanently reduced. Inflation is low and going to stay there for years to come. Since 1997 inflation fluctuating between 2% and 2.5%. Inflation premium set at 2% to 2.5%. It is the real rate of return that has declined. Real rate of return used to be between 3% and 4%. Today is about 1.7%. Argument is that bond yields are now at their historic average since 1831. That is the norm. The 1980s and 1990s high yield days were abnormal and not likely to return. Low LT rates are at the historic norm and are here to stay. Sustainable in the long term.
Implications of minority view: Markets will be less volatile. Investors more willing to buy longer term riskier assets. House prices remain at nosebleed altitudes, current stock valuations are sustainable over the long run. A prolonged capital investment cycle yields high profits from growing sales and inexpensive capital. Woo Hoo!
Party Pooper view: Low yields are really suggesting that the profit outlook is de minimus everywhere in the world. Corps are not spending on cap projects. Corps hoarding cash. increasing dividend payouts and buying back stock. Old bugaboo still holds-- inadequate aggregate global demand. Inadequate saving in US but massive saving overseas. US savings rate 1% Chinese savings rate 40%. World awash in savings and a lot of it winds up in US bond markets. But, LT rates cant stay low in relation to Feds policy of measured ST rate hikes. Despite a world awash in liquidity, dollar devaluation and slower productivity growth will push inflation higher forcing Fed to move faster with, presumably , even higher short term rates. In other words, current LT rate situation in US is not sustainable.
Questions for the board
Who's right here?
Is it possible we can be looking at a world of low (nearly no) yields on financial assets as far as the eye can see in a world of improving economic conditions, robust GDP growth, expanded trade, higher profits, and low inflation?. A world in which everybody gets healthy except the investor/lender? A booming worldwide economy with meager investment returns over the long run due to massive savings /worldwide liquidity resulting from miserable aggregate global demand? A world of low, low, low investor capitalization rates. ie., vanishing real rates of return falling into a black hole of oceans of surplus capital? (1.7% and going, going, going, gone?) Sure helps explain the current wacko market cap of the S&P 500, but how long can this situation of virtually giving your capital away for nothing persist? Is this combination of economic circumstances at all rational and sustainable over the long haul? What does all this imply for the prospects of FIRE for those of us who are going to depend upon the returns from financial assets down the line?
No offense to anybody. Just asking the question is all.
Donner
He examines the curious current state of low long term rates. The current 10 year Treasury Bond rate is hovering around 4%. Wall Street consensus is that will increase to 5.2% a year hence.
Wall Street fundamental case for higher long term rates: U.S. economy is strengthening; fear of deflation has evaporated; Fed raising short term rates on a measured pace; and, the twin deficits are getting larger. Why has the long end stayed so low? Wall Street says temporary factors including higher demand for bonds by underfunded pension plans, reduced supply from mortgage markets, the carry trade, and, Asian Central bank Treasury buys to prop up local currencies vs the dollar.
Alternative minority view: Long term rates are composed of two components an inflation premium combined with a real rate of return. Inflation expectations have been permanently reduced. Inflation is low and going to stay there for years to come. Since 1997 inflation fluctuating between 2% and 2.5%. Inflation premium set at 2% to 2.5%. It is the real rate of return that has declined. Real rate of return used to be between 3% and 4%. Today is about 1.7%. Argument is that bond yields are now at their historic average since 1831. That is the norm. The 1980s and 1990s high yield days were abnormal and not likely to return. Low LT rates are at the historic norm and are here to stay. Sustainable in the long term.
Implications of minority view: Markets will be less volatile. Investors more willing to buy longer term riskier assets. House prices remain at nosebleed altitudes, current stock valuations are sustainable over the long run. A prolonged capital investment cycle yields high profits from growing sales and inexpensive capital. Woo Hoo!
Party Pooper view: Low yields are really suggesting that the profit outlook is de minimus everywhere in the world. Corps are not spending on cap projects. Corps hoarding cash. increasing dividend payouts and buying back stock. Old bugaboo still holds-- inadequate aggregate global demand. Inadequate saving in US but massive saving overseas. US savings rate 1% Chinese savings rate 40%. World awash in savings and a lot of it winds up in US bond markets. But, LT rates cant stay low in relation to Feds policy of measured ST rate hikes. Despite a world awash in liquidity, dollar devaluation and slower productivity growth will push inflation higher forcing Fed to move faster with, presumably , even higher short term rates. In other words, current LT rate situation in US is not sustainable.
Questions for the board
Who's right here?
Is it possible we can be looking at a world of low (nearly no) yields on financial assets as far as the eye can see in a world of improving economic conditions, robust GDP growth, expanded trade, higher profits, and low inflation?. A world in which everybody gets healthy except the investor/lender? A booming worldwide economy with meager investment returns over the long run due to massive savings /worldwide liquidity resulting from miserable aggregate global demand? A world of low, low, low investor capitalization rates. ie., vanishing real rates of return falling into a black hole of oceans of surplus capital? (1.7% and going, going, going, gone?) Sure helps explain the current wacko market cap of the S&P 500, but how long can this situation of virtually giving your capital away for nothing persist? Is this combination of economic circumstances at all rational and sustainable over the long haul? What does all this imply for the prospects of FIRE for those of us who are going to depend upon the returns from financial assets down the line?
No offense to anybody. Just asking the question is all.
Donner